Quantitative Easing & the European Economic Crisis

Posted in Finance Articles, Total Reads: 1693
, Published on 18 December 2015

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As the European markets woke up on the day of January 15, 2015, a normal trading day turned into what would be one of the wildest in the Swiss market history. The unforeseen move by the central bank to lift the euro cap on the Swiss Franc saw the currency at a whopping 30 percent higher against the Euro within minutes. This decision of the Swiss National Bank (SNB) was driven by, among other considerations, a speculation about the action of the European Central Bank (ECB) in light of the slowdown facing the Eurozone.

The expectation of the SNB that the ECB will undertake a policy decision to increase the money supply in the economy was proven correct when the ECB president Optima 2014 28 Mario Draghi announced a major monetary policy in the form of quantitative easing by the European Central Bank to revitalize the Eurozone which was descending into deflation and recession. In the context of this article it is important that we are clear about what really is quantitative easing (QE). QE is a monetary policy undertaken by central banks wherein they buy securities, such as government bonds, from banks, with cash that is created in the form of electronic money.

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This policy instrument is utilized when direct variations in interest rates are no longer able to play their part in boosting economic activities. This policy works by pumping in money in the economy by increasing the quantity of bank reserves in an economy. Banks buy assets with the new money received, which results in raised stock prices and lowers interest rates therefore increasing money supply in the economy. This whole agenda results in stimulating investment. The policy of QE is also an important factor in countering deflation through, obviously, the increase in money supply. Given that a Central bank is perceived as serious about fighting the deflation, coupled with recession and unemployment, the economic activity is boosted due to the increased credibility of the economy.

Since QE, although an uncommon instrument, has displayed its potential as a means of economic recovery, in the few instances in the United States (after the 2008 sub-prime crisis), United Kingdom (in 2009 to give stimulus to a slowing economy) and Japan (2001 to push growth in a stagnant economy), many now perceive it favourably. Coming back to QE in Europe; the European Central Bank has announced plans to spend €60 billion ($70 billion) a month for at least 19 months, adding hefty purchases of government bonds to an existing scheme to buy covered bonds and asset-backed securities (currently around €10 billion-worth a month). The bank aims at creating more than € 1 trillion in assets by September 2016 to try an increase inflation in the Eurozone to a target of just below 2 percent (headline prices fell in the year to December by 0.2%) while core inflation (excluding volatile components like food and energy) was Optima 2014 29 0.7%. Incase the targeted inflation is not met by September 2016, the scheme is proposed to continue, “until we see a sustained adjustment in the path of inflation” as in the words of the ECB’s president. The proposed actions of the ECB have come up after battling through divisions, in regard to this programme, among the policy makers on the bank’s governing council. However, Mr. Draghi said this landmark step was supported by, “a large majority [of the ECB’s governing council], so large we didn’t need a vote.” The QE is expected to work through two ways in the Eurozone. One is the through the exchange rate. The already weakening euro is expected to weaken further, thus increasing exports and boosting inflation. The second manner in which this policy is to work is through the “signaling effect”. The ECB, by undertaking QE is sending a clear and credible message about targeting inflation, thus increasing confidence in the Eurozone.

However, the degree to which this policy is effective is dependent on the European nations’ current institutional step-up. Analysts believe that Germany and Greece will be losers in this programme. German opposed this programme prior to its announcement, wherein the Finance minister Wolfgang Schaeuble described Quantitative Easing as “not the solution, rather the cause [of economic woes]”. Germany has in the aftermath of the crisis believed that this step will only be marginally beneficial and may create “noticeable increased risk of asset price bubbles, of mistaken risk assessments and misdirected investment,” as said by Michael Kemmer, chief executive of German Bankers Association. Special rules are in place for countries like Greece that have received bailouts. Greece has been currently excluded from this bond-buying programme. Inclusion will take place once Greece successfully repays money from the previous bonds. The inclusion will also be dependent on whether Greece remains a part of the Eurozone or decides to secede. The plan has been deemed beneficial to countries such as Portugal, Italy, Spain and Ireland, which are on the recovering from high debts. Due to high debts these countries will feel more, the benefits of the reduced borrowing costs and lower interest rates. This programme of QE is, however, different from the one imposed by the US Federal Reserve and the Bank of England. This is because the policy was unexpectedly undertaken in these two nations and thus yields dropped drastically.

In Europe this policy has long been expected. A few countries already undertook measures prior to the January 22nd decision, in anticipation of it. This might undermine the effect of the Quantitative Easing put into place. Another difference lies in the structure of their financial markets. The European firms rely more on banks in contrast to American firms, which work largely in the capital markets. This also reduces the benefits in the Eurozone as the American firms, due to these differences gained more from the falling yields. Optima 2014 30 The perceptions about the effects of this policy are still divided. Central banks are being cautious in the use of QE incase the circulation gets out of hand. These banks are also exploring a number of alternatives.

However, it was necessary that amid the ongoing state of the European countries a major policy decision be undertaken. Given, the absence of any unforeseen economic upheavals, hasty investments decisions and unmanaged cash flows to emerging economies, this policy could help at least a few of the Eurozone nations to find their way out of the prolonged crisis.

This article has been authored by Arushi Anand from Great Lakes Institute Of Management